WHAT PRICE CAPITAL? THE COST OF HOLDING ABS

The proposed capital charges under the Basel III and Solvency II regimes are detailed and complex, and subject to on-going consultation (and recalibration) by the mandated regulatory agencies. The purpose of this article, therefore, is to highlight the current status of proposed capital charges under the two regulatory regimes. Such capital charges (even after some element of softening) are generally considered within the ABS industry as being prohibitively conservative, potentially make the holding of ABS uneconomical and deterring investors (i.e. banks under Basel III and insurers and pension funds under Solvency II) from holding such assets.

We will look at three areas in which the capital cost of holding ABS, if implemented as currently proposed under Basel III or Solvency II (as applicable), is likely to have a profound impact on the ABS industry.

(1) Capital costs of holding ABS under Basel III

The table below shows the proposed risk weightings to be ascribed to securitisation positions under the Basel Committee Consultation Paper entitled “Revisions to the Securitisation Framework” of December 2013. The table shows that capital costs of holding securitisation assets can generally be expected to increase (substantially) as a result of implementation of Basel III, particularly in the case of highly rated, short term assets. The Basel Committee did make a move towards less prohibitive capital costs for such assets under the second consultation documents but positions remain significantly above the capital requirements imposed under Basel II for highly rated securities.

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The Basel Committee has attributed the proposed increase in capital costs to (among other things) the poor performance of highly rated securitisation assets (albeit over a relatively short time period). More specifically, the Basel Committee cited the following factors in concluding that risk weights under the existing securitisation framework are insufficient:

  1. A misplaced assumption that credit losses of securitised assets were less correlated with specific global risk factors than similar assets retained by the relevant financial institution. The Basel Committee believe that questions can be raised regarding the previously-perceived benefits of diversification that securitisations were expected to provide.
  2. A failure to adequately allow for maturity risks. In addition, the Basel Committee believe that the current system does not adequately address tranche thickness or type.
  3. Other questionable modelling assumptions.

Finally, it is interesting to note that the Basel Committee consider existing risk weights for lower rated securitisations to be too high, and has proposed decreases as a result.

(2) Capital costs of holding ABS under Solvency II

The table below shows the capital charges proposed by EIOPA (the European Insurance and Occupational Pensions Authority) pursuant to the “Technical Report on Standard Formula Design and Calibration for Certain Long-Term Investments” of December 2013, and the “Technical Specification for the Preparatory Phase” of April 2014. The papers serve as a recommendation for the European Commission for the purposes of implementing Solvency II.

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The Report makes a distinction between ‘Type 1’ and ‘Type 2’ securitisations2,and it is easy to see from the above table the capital cost implications for the distinction. The criteria for Type 1 securitisations are extensive, and just a few of these are listed below for illustration:

  • The securitisation must be listed in a regulated market in an European Economic Area or Organisation for Economic Co-operation and Development country.
  • The relevant tranche must be unsubordinated on enforcement/acceleration.
  • The underlying assets should be held by a special purpose entity on a solvency remote basis.
  • The underlying assets should be either RMBS, SME loans, auto-loans, property leases, credit card receivables or other consumer loans (this helpful includes most types of ABS).
  • Of particular consternation for the ABS industry is the stark comparison to the proposed capital charges for corporate bonds having equivalent credit worthiness, as highlighted in the table below:

Click here to view table.

At the time of writing, it is expected that the European Commission will shortly announce a reduction in the proposed capital charges for ABS. In the case of Type 1 securitisations rated BBB or higher, capital charges are expected to be halved. However, disparity with the treatment of corporate bonds is likely to continue to be a cause of some frustration.

(3) The Liquidity Coverage Ratio under Basel III

Basel III introduced for the first time the Liquidity Coverage Ratio or “LCR”. Put simply, the Liquidity Coverage Ratio requires that banks maintain sufficient “high-quality liquid assets” to survive a significant stress scenario lasting for a period of one month. The idea is that, under such conditions, the bank in question would hold sufficient liquid assets (i.e. assets that could be immediately turned into cash for equivalent or close-to-equivalent value) in order to survive a hypothetical stress scenario.

The European Banking Authority (EBA) has been mandated to develop the concept of high-quality liquid assets, and in this regard distinguishes between assets of “extremely high” and “high” liquidity and credit quality. In its report of December 2013, the EBA determined which assets would be considered to be of “extremely high” or even “high” liquidity or credit quality, and which assets would be deemed to be of insufficient liquidity – see below:

Click here to view table.

The EBA specify further conditions in order for RMBS to qualify as high liquidity assets. These include the conditions that the underlying residential mortgages must be first-lien, only senior tranches may be included, and other conditions relating to maturity and prepayment rate. A 25% haircut would also apply to RMBS when calculating the contribution to total stock of high-quality liquid assets. Finally, the combination of RMBS and lower-rated corporate securities (known under Basel as ‘level 2B assets’) may only account in aggregate for 15% of the total high-quality liquid asset holding needed to comply with the LCR.

The findings of the EBA can be viewed in both a positive and negative light. There is an acknowledgement of RMBS as high-quality liquid assets (notwithstanding the additional conditions, haircuts and limited contribution) which is an indication that regulators may be more willing to recognise ABS assets as equivalent to other securities having a similar credit rating for regulatory capital purposes, however the failure to include other highly rated ABS assets even if widely traded limits the likely liquidity and attractiveness of this product in the future.

Conclusion

The higher capital weightings applied to ABS highly rated tranches and the lack of recognition of high credit quality and liquid tranches of ABS for LCR purposes are both likely to cause difficulty in the development of an active and effective market in high grade ABS. Both measures limit the range of assets that can be held by banks and insurance companies on an on-going basis, thereby increasing systemic risk and both measures further limit the availability of funding to businesses and consumers as banks reduce lending that cannot be securitised to meet balance sheet constraints.